Overview • Demand • Supply • Underlying principles • Factors impacting supply and demand • Special S&D curves • Chapter 4 in text
Demand • Various quantities of a commodity that an individual is willing and able to buy as the price of the commodity varies holding all other factors constant.
Law of Demand • All else equal consumers will by more of a item at lower prices and buy less at higher prices. • Demand begins with individual consumer • Inverse relationship between quantity and price • Two dimensional, Price and Quantity
Downward Sloping Demand Curve Px A PA B PB D QA QB Qx
Downward sloping demand • Begin with individual’s utility function and a budget constraint • Substitution effect • consumers buy what’s cheaper • Income effect • “income” increases if prices fall
Representation of Demand P Q Q = 14 – 2xP
Market or Aggregate Demand • Add individual demand curves • Horizontally across consumers • http://www.aaec.vt.edu/rilp/Demand%20Changes-2000.pdf (Pages 1-10)
Aggregate Demand • Add horizontally across consumers at each price Market 1 2 3
Change in Demand orin Quantity Demanded Moving from A to B due to a price decline is a change in quantity demanded by moving along the same demand curve. Px A A shift in demand is a move from B to C as the curve shifts from D1 to D2 B C D2 D1 Qx
Factors that Cause a Shift in Demand • Price of substitutes • Price of complements • Consumer income • Taste and preferences • IS NOT FUNCTION OF THE GOOD’S OWN PRICE
Factors that cause a shift in aggregate demand • Population • Exports • Consumer income • Advertising • New information • Product differentiation • New product development • Government intervention
Observing Demand in Data • Each P and Q are an equilibrium point where supply equals demand at a point in time. • Demand typically more stable • As supply changes the demand curve is traced out
Inverse Demand • Price is a function of quantity • P = f(Q) • Important in agriculture • Short run supplies are relatively fixed • Prices change to clear the market
Supply • The amount of a given commodity that will be offered for sale per unit time as the price varies, other factors held constant.
Law of Supply • An economic principle that states: All else equal, producers are willing to sell more products at a higher price than at a lower one. • Positive relationship between price and quantity • Curve slopes up and to the right
Supply • Derived from cost function • Production function • Input - output relationship • Assume that firms seek to • Maximize profits • Minimize costs • Supply starts will individual firm
Production Function Output Total Product Decreasing returns to the input Increasing returns to the input Input
Cost Curves • Average variable cost = AVC • Total variable cost / Q • Total variable costs change with Q • Average fixed cost = AFC • Total fixed cost / Q • Total fixed costs do not change with Q • Average total cost = ATC = AVC+AFC
Cost Curves • Marginal cost = MC • Change in total cost by producing 1 more • TC / Q
Cost curves Cost MC ATC AVC AFC Q
Profit for the firm • Profit = total revenue - total cost • TR= P x Q • TC = ATC x Q • Profit per unit = Profit/Q • = TR/Q - TC/Q • = P - ATC • Profit maximizing Q • MC=MR=P • Profit/Q = P-ATC at optimal Q
Optimal Q at P=MC Cost MC P2 ATC AVC P1 Q1 Q2 Q
Cost curves and supply • Operate if ATC > P > AVC • Shut down if P < AVC • Lose on every unit produced • P>AVC make some payment to fixed cost • In the long run everything is variable • Short run defined by having fixed cost • Long run supply curve for individual • Low point on ATC curve
Supply curve • MC curve above AVC curve • Upward sloping curve • Optimal output @ MC = MR • MR = Price => Optimal at MC=Price • The last unit of input just pays for itself • The change in the cost of the last unit is equal to the change in revenue of the last unit.
Market or Aggregate Supply • Combination of individual supply schedules • Add horizontally across firms A B C Market
Market supply curves S1 Move from A to B is a change in quantity supplied due to a price decline. Px S2 A B C Move from B to C is a shift in supply. Qx
Supply Shifts from Change • in input prices • in returns for competing enterprises • in price of joint products • in technology on yields or costs • in yield and/or price risk • institutional constraints • SUPPLY DOES NOT CHANGE DUE TO A CHANGE IN PRICE OF THE OUTPUT
Following Supply Shift • Firm level decision to supply shifter • Market impact of firms’ decision • Firm response to price reaction
Supply Shift from Cost S1 Cost MC2 S2 MC1 P1 P2 D Q1 Q2 Q Q1 Q2 Q Firm Market
Steps to shift curves • The impact changes the MC curve of the firm. • The firm chooses output so that MC = MR. • Market supply shifts. • Price moves along demand curve to new level. • Repeat steps 2 - 4.
Market supply curves flatten out over time SLong run SShort run Px Qx
Price and Costs in Ag • Short run • Not necessarily a relationship between cost and price • May be profit or loss • Long run • Firms expand output to profits and reduce output to losses • Average price = Minimum Long Run ATC
Economies of scale • Average total costs changes as the output of a firm changes • Increasing, decreasing or constant economies of scale. • Short run cost curve (SRATC) • Long run cost curve (LRATC) • Change across range • L-Shaped cost curve
Externalities and cost curves Cost • Cost or benefit not perceived by the firm • Internal cost curve • Cost curve if external cost included Q
Processing cost curves • Specialized plants/equipment • High fixed cost • Low flexibility Cost SRATC Q
Law of One Price Definition: Under competitive market conditions all prices within a market are uniform after taking into account the cost of adding place, time, and form utility.
Marketing Adds Value • Time utility: Storage • Form utility: Processing • Place utility: Transportation • Does the added value offset the added cost? • Is the cost the same for everyone?
Law of One Price • Reason the Law of One Price Works: Arbitrage • Profit seeking individuals acting in their own self interest • Sellers, Buyers, Middlemen • Buy low and sell high for profit by changing time, space, and form
Law of One Price • Arbitrage opportunities • Transportation • Storage • Processing • How much price difference is sustainable between the two markets?
Seasonal Grain Prices • Storable commodity • One harvest period • Used throughout the year